The way Glenn Pollack sees it, everyone believes the deal is structured right — until it isn’t.
“The debt guys believe they have adequate security and adequate covenants to control their destiny at some level,” says Pollack, founder of Candlewood Partners. “The equity guys believe they have adequate flexibility and adequate capital to reach the objectives they have outlined in their proformas. That’s the essence of it.
“Where it blows up is when the equity guys are too rosy and are willing to overlever their position, hoping that they’ll be able to reach the objectives they’ve outlined in their forecasts.”
Pollack has advised more than 150 middle market companies in various corporate finance transactions, developing and implementing innovative capital structures and alternatives to traditional financing methodologies.
We caught up with him to get some of his insights on building strong capital structures, restructuring transactions and the risk of selling to private equity.
What’s the key to developing a strong capital structure?
It depends on how you define business owner and what size the business is. In a small business, it’s extremely difficult because whatever you make, you want to take out as income and every dollar you take out weakens the balance sheet. For a large business, the ability and flexibility is much greater to create a strong balance sheet either by raising equity, using preferred stock, paying down debt or retaining significant earnings to allow that balance sheet to toughen up. It is definitely size and ownership related.
What’s your advice for companies that are seeking capital?
It depends on the type of capital that you are working to attract. There are family offices that want to make investments for a longer term. There are lenders of different stripes who have a very narrow and defined term. If you get your capital from a sub-debt provider who calls it either sub-debt or preferred, they have a limited horizon on their source of capital, except for some business development companies, which have perpetual capital. Non-BDCs have a horizon on their capital. They are going to want to see a liquidity event where they get capital back and a return on their capital. You have to be very clear about what you’re doing, how you’re getting it and what it means.
What do you enjoy about working on a restructuring transaction?
There are two sides of a restructuring deal. One is operational and the other is the balance sheet. For the first 10 years of my post-accounting career, I was focused on operations. For the last 20-some years, I’ve been focused on the balance sheet. It’s essentially the allocation of limited value to multiple competing parties. It’s a zero-sum negotiation structure, which is what I enjoy doing. When you’re doing a restructuring, there is only so much value. For me to get some, you have to give up some. It’s zero sum. It’s finite and included in that finite value is potential future value. But it is all finite.
But restructurings are not what they once were. The market and what we’re doing and what people are more interested in is what capital structures look like now in a refinancing or an acquisition environment. What we see is that there is a continued tendency for private equity shops to use significant leverage to enhance their returns.
You’ll see transactions that are levered four, five or six times. But in the private deals we’ve seen, equity holders and buyers are more concerned about balance sheet strength and elimination of risk. We’re seeing much stronger equity capitalization together with covenant-light debt or preferred equity that are significant components of the capital structure.
What’s your philosophy on working with private equity?
If you’re thinking about small business owners or family-owned businesses, where the founder or family operator is concerned and rightfully so about control of the family business, not all decisions around that business are rational business decisions. The family is thinking about the next generation and the generation after that. When they are involved with PE firms, in large part, those firms buy into companies and view each company as an option in their pool of options. Their focus is generating an overall return to that pool so that they can make money and raise their next fund.
Your success may lead to an adverse reaction. If that private equity firm, if the certain fund that you’re in has weakness and they are trying to raise a new fund and they can sell you for a lot of money and boost their returns, even though it may not be the time to sell, that may be their conclusion that it’s time for them to sell. They’re not managing the business for the family’s benefit. They have other interests that supersede even the business. That’s why people are worried about private equity and selling equity.
Any final pieces of advice?
Make sure you’re not overlevered. The quickest way to lose value is to run out of cash. Look at your capital structure and look for ways to modify it, even if it costs you something, so that you can ensure that you’ll retain the long-term opportunity. Half of a large pot is better than 100 percent of a tiny pot.